Reason behind the asset bubble

Not only has money supply (M3) been rising in recent years, but it has also gone up sharply as a proportion of nominal gross domestic product (GDP). Here’s the data: The annual increase in M3 as a proportion of GDP in that year was 9.1% in FY02; 9.0% in FY03; 11.1% in FY04; 10.1% in FY05; 12.4% in FY06 and as much as 15.7% last fiscal.

M3 growth in a year should normally be at least equal to the increase in goods and services plus the rise in the prices of these goods and services, which is nothing, but nominal GDP. But as the numbers show, M3 growth has been well above the growth in nominal GDP, especially in the last two years.

What does this trend indicate? Says Ajit Ranade, chief economist of the Aditya Birla Group: “Part of it is the result of financial deepening, as the use of money becomes more and more widespread.” But the extra liquidity could also be spilling over into higher asset prices. The rise in goods and services is captured by nominal GDP, but the rise in asset prices is not.

Gaurav Kapur, senior economist with ABN Amro Bank, says that rapid M3 growth is a reflection of the sharp rise in bank credit. “Bank credit as a proportion of nominal GDP too has gone up,” he says, ”partly because banks have discovered retail lending.” Kapur also agrees that part of the M3 increase, beyond that required for the real economy, has been boosting asset prices.

This fiscal, the Reserve Bank of India wants M3 growth to decelerate to 17-17.5%, while real GDP growth is pegged at 8.5% and inflation at 5%, giving a nominal GDP growth rate of 13.5%. That will mean the M3/nominal GDP ratio will be 13.8% in FY08, well below last fiscal’s 15.7%.

Matrix Labs

Mylan’s takeover of Merck’s generic business saw the Matrix Laboratories Ltd stock move up 12.65% on Monday, in anticipation of more business moving to India. The stock has fallen by 25% since the announcement of the Mylan takeover last August, but had been moving up recently partly because of the Merck deal and partly due to Mylan’s winning 180-day exclusivity to market the generic version of Pfizer’s hypertension drug Norvasc.

One of the reasons for the Matrix stock’s severe underperformance has been its poor performance, with a net loss in the December quarter. Revenue losses and write-offs in the US generics business, and an increase in interest costs have hit Matrix’s bottom line.

But surely the additional business from Mylan will help? Matrix was expected to benefit for two primary reasons—one, higher API (active pharmaceutical ingredients) volumes as a consequence of sourcing from Mylan and higher anti-retroviral (ARV) volumes. The second benefit is already apparent in the recent deal with the Clinton Foundation, which expands the reach of Matrix’s ARV drugs. It is also possible that the rising interest cost of the Merck generics deal may force Mylan to shift products to Matrix more rapidly.

But that will take time. Although the stock has zoomed, analysts caution that even though volumes may increase as a result of the Mylan connection, margins may take a hit. Progress on the DocPharma integration also needs to be watched.

The need for generics players to expand to counter margin pressures will drive consolidation and vertical integration in the business. The stocks of smaller generics companies in India have been moving up in anticipation.